EV

It works on this simple premise: Imagine you’re selling ice-cream, and tomorrow there’s a 50% chance of rain, and 50% chance of sun tomorrow, so on that point, would you want to stock up 50% lesser on ice-creams? Of course not, you still stock up 100% ice-creams in case it could be sunny tomorrow.

Expected value is just a mathematical calculation that uses probabilities to interpret various outcomes, so it is not an exact or real outcome that will happen.

You must also consider, how do you arrive at these probabilities estimates? You will only know from past experience (or past data), hence it is not a really accurate prediction of a future outcome but more of a prudent one at best.

EVs are long-time averages and are not always suitable for one-off decisions. This will not be relevant to the risk-attitude of managers, like those who want to maximise returns as risk increases, or seek to make minimum returns if they’re not too comfortable with the high risk.

Consider the fact that the economy is under a recession, hence it’s no longer about the shareholders’ pressure on a company to maximise profits, it’s more on the pressure to keep the company surviving. EVs using subjective probabilities that are not fully reliable may lead you to take a wrong decision.

Useful practice questions:

1) Dec 2011 – Q1 Mackarel (*Best question*)

2) June 2010 – Q2 Equine Management Academy

3) June 2009 – Q2 Franchising 4 U

4) Dec 2006 – Q1 Wonderland

5) Dec 2005 – Q1(b) Envico Ltd